The 6% decline in the Nasdaq index since its year-to-date high on March 12? Blame much of that on just five stocks. Yes, just five companies account for more than 40% of one of America’s major stock indexes.
It’s no secret that markets have been flailing this year, and some of the biggest names have been hit the hardest off their 2018 highs. Alphabet (parent of Google) has dropped nearly 13%, while Facebook has been pummeled 15%. Apple is down 4%, while Amazon has plunged more than 9%.
This movement exposes one of the Nasdaq index’s biggest risks — its huge reliance on a few stocks. If you’re buying a fund that matches or tracks the index, you need to know how much the Nasdaq relies on this handful of stocks.
What is the Nasdaq 100 index?
More than 3,300 companies are listed on the Nasdaq exchange, but the 100 biggest and most successful make up the Nasdaq 100 index. When investors say “Nasdaq,” they usually mean “tech companies.” The index includes such heavyweights as the four companies above and other top players such as Microsoft, Intel and Cisco.
Investors in a Nasdaq index fund should understand how top-heavy the index is.
Investors buy a Nasdaq 100 index fund for one of the same reasons they buy other index funds: instant diversification. One fund immediately reduces your risk by owning a wide selection of companies across many industries. The fact that the Nasdaq is largely tech companies may make it seem undiversified. However, tech comes in many flavors — including semiconductors, software, social media, e-commerce, cable and exbiotech — so it’s more diversified than the label suggests.
But not all index funds immediately guarantee perfect diversification, and investors in a Nasdaq index fund should understand how top-heavy the index is.
The Nasdaq 100 weights companies by their market capitalization, so bigger companies weigh more heavily. (Market capitalization is a gauge of size; multiply a company’s outstanding shares by the price of a share.) The bigger the company, the higher its percentage of the index. The table below shows the highest-weighted companies — they’re not just large caps, they’re mega caps.
|Alphabet Class C||4.988%|
|Alphabet Class A||4.256%|
The critical point to note is just how concentrated the index is in its top companies. The top five account for more than 40% of the index, and the top 10 more than 54%. So if these stocks cough, the whole index gets a cold. For example, if the top 10 moved down 1%, the index’s other 90 stocks would have to move up more than 1% just to keep the index’s overall performance flat.
But what happens when a huge index moves down? A move down often causes a huge change in investor sentiment. Investors become afraid to buy those other 90 companies, even if they’re largely unrelated to what the biggest companies do. So the index’s over-reliance on its biggest stocks provides an extra measure of riskiness to the Nasdaq, helping to cause or exacerbate market downdraft, such as that of early 2018.
» Read more: Everything you need to know about a market crash
How does the Nasdaq compare to the S&P 500 index?
The Nasdaq index is similar to another bellwether index, the Standard & Poor’s 500, but the latter is more diversified. The S&P comprises 500 of America’s largest publicly traded companies, but its concentration in its biggest names is much lower.
|Johnson & Johnson||1.523%|
|Alphabet Class C||1.479%|
|Alphabet Class A||1.461%|
In the S&P, the top five names make up just over 13% of the index, compared to more than 40% on the Nasdaq. The top 10 account for less than 21% versus the Nasdaq’s 54%. So while the S&P has concentration in its top names, it’s much less than the Nasdaq.
All five of the top Nasdaq stocks are also top holdings in the S&P fund
Another risk to watch out for, though it’s small: All five of the top Nasdaq stocks are also top holdings in the S&P fund. So if you already own an S&P fund, adding a Nasdaq fund to your portfolio probably won’t do as much for your diversification as you expect. But if you want a larger helping of tech than the S&P provides, a Nasdaq fund could be a good addition.
Potential plans of action
There are no called strikes in investing. You get to pick an investment that fits your temperament and investing style. Here are some potential action plans:
If the Nasdaq as designed worries you: Buy a different kind of Nasdaq fund. While the traditional Nasdaq index is market-cap-weighted, some Nasdaq-focused indexes avoid the problem of concentration by using equal-weighted positions. In an equal-weighted index, each of the Nasdaq 100 companies makes up 1% of the index, so the fund is not overexposed to any single stock. The downside is that you won’t own much of the companies that have dominated the tech world over the past few decades.
If having too much Nasdaq exposure worries you: Add an S&P 500 index fund. This solution is simple — decrease the weighting of the Nasdaq in your overall portfolio. Invest some of your money in an S&P fund, or in other diversified funds that have smaller or no positions in top Nasdaq stocks.
If you want to go big on tech: Stay invested in the Nasdaq and buy more. Considering the runaway successes of Alphabet, Amazon, Apple, Facebook and Microsoft, it may ultimately be better to live with the increased riskiness of investing in the Nasdaq in order to enjoy the increased reward of riding along with these market-thrashing companies. If you want more exposure to some of the smaller companies in the index, you could then add an equal-weighted fund.
If you’re ready to plunge into the Nasdaq or any other index, it couldn’t be easier to buy an exchange-traded fund (ETF) based on the index.